Stockwatch: Buy while sentiment is weak

This firm is a market leader of essential services with many strong client relations based on technical expertise. Companies analyst Edmond Jackson think it's worth backing.

Does an overall rally this year in the mid-cap shares of oil and gas engineering/services group Petrofac Ltd  - along with fairly robust trading updates - signal last year's fears linked to a Serious Fraud Office investigation were overdone?  

Or does volatility in the stock’s recovery imply downside risk also, if Petrofac’s founder-CEO is not fully exonerated?  Short sellers continue to lurk.

Denial, yet a sacrificial body overboard

I last drew attention at 454p mid-December 2017 after a trading update, noting the group’s tendering activity remained high amid ongoing strength in key operations, despite a total 8% of the issued share capital sold short. 

•    Stockwatch: This stock is fundamentally cheap

The stock's risk/reward profile appeared to weigh on the upside, having traded closer to 1,000p before industry-wide investigations began into the Unaoil bribery scandal.  At issue is whether Petrofac paid Monaco-based Unaoil to act as a middleman, paying officials in order to secure service contracts.  

Petrofac’s initial response was to deny any wrongdoing, although it suspended its chief operating officer.  The board later concluded, restrictions imposed initially on the chief executive were inappropriate and he resumed full executive responsibilities.  

No real effect on client confidence

At issue is not really the extent of any fine, but reputational effect of the SFO’s findings, whenever a conclusion is reached.  The stock has traded in a volatile-upwards range of 400p to 650p this year - currently 560p - amid resilient contract news, although it's hard to discern the net upshot until a 26 June update cited new order intake of US$1.8 billion (£1.4 billion) in respect of the first half year versus $1.7 billion a year ago, while the trend in backlog (work in progress) continues down from $13 billion at end-May 2017 to £10.2 billion end-December then $9.7 billion last May.  

Various factors could be involved, though an explanation would have helped given changes in backlog tend to be seen as a forward indicator for contracting groups, and it doesn’t suffice to try and reconcile the narrative on divisional operations.

Source: Company REFS            Past performance is not a guide to future performance

Oil price strength has provided a boost

Oil & gas industry service shares do tend to track their commodity prices. Indeed, I’ve seen industry comment where service demand is affected also in the very near term.  Oil’s 2018 rally follows chiefly from the OPEC cartel being a lot more successful at achieving production cuts than the market anticipated, also US shale producers not disrupting a tighter market like they are prone to.  

Lately, the resumption of US sanctions on Iran has squeezed prices even higher despite OPEC saying it will make up any shortfall from Iranian exports.  Coincidentally, output from Libya and Angola has fallen more than expected and US crude/fuel oil inventories also fallen amid supply disruptions, just as there is peak annual demand in the car-driving season.  

Such a conflation of bullish factors has prompted Morgan Stanley to raise its H2 2018 Brent crude oil target by $7.50 to $85 versus $78 currently, just off its three-and-a-half-year high of $80.50 in May; and should be supportive both of Petrofac’s fundamentals and sentiment towards its stock.

Chairman's resignation: a red herring as to risk

When I last drew attention in December, media headlines focused on a separate RNS about the chairman signalling his intention to leave: e.g. "Petrofac chairman heads for the exit as SFO probe rumbles on.”" 

True, any non-executive director’s most powerful weapon when dissatisfied is to resign, signalling to investors it’s also not within their power to improve a situation, but this was not a sudden departure, instead an orderly succession of stepping down at the May 2018 AGM after four years as chairman (11 as a director) with the senior non-executive director assuming the chair.  

Good practice in corporate governance is for independent directors not to get ensconced.  While his 14 December 2017 resignation RNS didn’t include any words about confidence in prospects, at the AGM he said:

"Petrofac has a clear, focused strategy and I have every faith it will continue to grow and prosper over the longer term."

Yet the short position has risen to 9.4%

In the first four months of this year the number of short positions open fell to about 6%, but during June it has spiked up to 9.4% with seven of nine disclosed traders raising their short exposure, one no change and another down 0.1% - i.e. a definite sense to counter market strength despite nothing adverse in Petrofac's announcements.  

Possibly some are using the stock to hedge against a strong oil price this year, say if global growth hopes for 2018 prove less than rosy and oil demand falters in due course.  Whether or not these traders have better insight than anyone else, just be aware they retain a negative view of Petrofac and are using market strength to reinforce it.

Analysts still envisage "recovery to growth"

The table shows consensus for a profits rebound this year and next, implying a prospective price/earnings (PE) multiple around 11 times falling to just 8, the dividend yield rising towards 5.5% covered twice by earnings.  

If realistic, this would mark the company moving onwards and upwards from its volatility of recent years.  Not surprisingly, the stockmarket awaits proof, and perhaps an element of trend-following accentuates the price swings.  Some investors are likely to continue to avoid Petrofac until the SFO gives its verdict, and after 14 months it's still impossible to say when, although Petrofac’s board has backed its chief executive.

The stock had anyway been in a downwards trend from 1,463p in April 2014, then volatile-sideways from 2015 to May 2017 when the Unaoil-linked investigation broke.  The company’s profits de-rating shows the market’s judgment as correct, the question is whether current pricing remains jaundiced in response to the inquiry.  It’s an uncertainty investors have to live with, so know your own risk appetite.

Conclusion remains positive

My stance is Petrofac being a market leader of essential services with many strong client relations based on technical expertise; hence, it pays to accumulate a stock like this while sentiment is against it.  

If the CEO becomes discredited then a takeover becomes likely.  You can’t eliminate an aspect of speculation here, but, unless the global economy slumps taking oil prices back down, the fresh wave of short selling lends another opportunity.  Speculative buy.

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.